Hedging Strategies: Livestock and Meat Complex

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Hedging Strategies Livestock and Meat Complex
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The Livestock Futures Market Complex

• Consists of Feeder cattle, live or fed cattle,
  hogs, pork bellies, cheddar cheese, nonfat dry
  milk, fluid milk, butter, boneless beef and
  shrimp
• Currently, cattle, hog and pork bellies contracts
  are most viable contracts.
• Cheddar cheese and nonfat dry milk was introduced
  in New York Coffee, Sugar and Cocoa Exchange in
  1993
• Shrimp contract was started in Minneapolis Grain
  exchange in 1993.
• CME added boneless beef, boneless beef trimming
  and ground beef in 1997

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The Cattle Producer

• Cow-calf operation Perform the breeding,
  gestation and delivery of calves.
• Once the calves are born, the process include
  providing the time and environment for calves to
  put on additional weight.
• The livestock operation can be broken up several
  times by different firms providing different
  aspect of the growing process.

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Cattle Futures contracts

• Two futures contracts can be used for hedging
  the feeder cattle contracts (700-849 pounds
  animal) and the live (fed) cattle
  contract(1,100-1300 pounds animal)
• Each of the livestock contracts call for a semi
  truckload unit
• Feeder cattle 50,000 pounds
• Live cattle 40,000 pounds
• In addition, CME has also listed some products
  such as boneless beef and ground beef.

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Hog Producers

• Hog producers either produce hogs from farrow
  (birth) to finish or buy feeder pigs at
  approximately 50-75 pounds and feed them to
  market weight usually in the range of 210 to 230
  pounds.
• Hog feeding period varies from three to four
  months
• The feeding period varies depending on age,
  condition, the breed of hogs and feeding condition

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Hog Contracts

• Hog contracts allow both barrow (castrated male)
  and gilts (nonpregnant female) that averages 220
  pounds.
• Since there is no feeder pig contract, only the
  live market hog contract can be hedged.

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Production Hedge

• The price risk in livestock production is the
  same as for grain and oilseed products i.e.
  decline in price during production process.
• Livestock production hedges are short hedge

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Live Cattle Hedge

• Either anticipatory or purchased hedges.
• An anticipatory hedge is one that is placed by
  someone that has the cattle in a growing program
  and anticipate that they will put them in a
  finishing operation.
• A purchased hedge is placed by someone who buys
  cattle they are ready to be put into a finishing
  program.

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Live Cattle Hedge

• In anticipatory hedge risk is that while the
  cattle are growing and being finished in the feed
  yard, the price of live cattle will decrease.
  Sometime far enough to eliminate all profit
  margins.

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Live Cattle Hedge

• A purchased hedge is very similar to anticipatory
  hedge. The only real difference is that the
  cattle are purchased and immediately put on feed.

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Hog Hedge

• Either anticipatory or purchased hedges.
• An anticipatory hedge is one that is placed by
  someone that has the hogs in a growing program
  and anticipate that they will put them in a
  finishing operation.
• A purchased hedge is placed by someone who buys
  hogs they are ready to be put into a finishing
  program.

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Feeder Cattle Hedge

• A production hedge for feeder cattle (650-pounds)
  are typically used by two types of producers
• Cow-calf producers who carry the calves to feeder
  cattle weights
• Involves in breeding, gestation, and growth of
  the animals from calves(less than 75 pounds) to
  feeder cattle (650 pounds)
• Feeder cattle producers
• Not involved in the breeding, gestation. Cattle
  feeder purchase lightweight calves (250-550
  pounds)

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Investing as a speculator

• Speculators in futures markets do not own or
  control the underlying commodity.
• They invest in futures markets to try and capture
  profits from price movements/price forecasting.
• The major attraction of speculative investors to
  the futures market is the leverage made possible
  by the margin system.

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Investing as a speculator

• There are three major ways in which to invest as
  a speculator in the futures markets
• Short term
• Long term
• Spreading
• Short term Investors who trade on a daily or
  within-the-daily basis to profit from the price
  fluctuations

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Short term speculators

• The most celebrated of all day traders is the
  scalpers (also known as locals)
• Mostly exchange members
• Trade on very small price movements and
  concentrate on a large volume of trade to
  generate income
• Locals usually end the day without holding any
  open position, i.e., they offset all the trade by
  the end of the day.

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Functions of Locals

• Locals provide the necessary liquidity to keep
  futures markets functional.
• Without the locals willingness to accept short
  term price risk, the market would definitely lack
  the necessary level of liquidity to function
  smoothly.

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Example of local trading

• The local bought a March corn at 2.02 per bushel
  on February 17, 2001 at 10.01 AM.
• Corn price increased to 2.03 at 10.03 AM.
• Local will sell his position for a penny gain.

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Long Term Speculators

• Any trade held longer than a day to several
  months is considered a long-term investment.
  These traders are known as position traders.
• Unlike day traders, position traders concentrate
  on large price movements.

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Spreaders

• Spreading involves price relationships in two or
  more markets.
• Spreaders try to estimate price relationships
  between or among close related markets and try to
  take advantage of any abnormality.
• Example Consider corn futures prices for March
  and May contract. Price difference between these
  two contracts should be carrying charge.
• If the average carrying charge is 3 cents per
  month, then the normal relationship between March
  and May futures should be 6 cents.
• If the difference is 8 cents then you would put a
  spread by buying March contract and selling May
  contract.

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Spreaders

• A similar situation exists when the spread is
  narrower than normal.
• Reverse spreading relationship on corn futures
• Feb 1 March corn is trading at 2.1 and May corn
  is trading at 2.14
• Sell March corn and buy May corn
• When the spread relationship has gone back to
  normal, lift the reverse spread

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Spreaders

• Spread investing is relatively less risky because
  gains made on either the buy or sell side are
  usually offset by losses on other side.
• The margin requirement for spread is much less
  than for short or long-term speculator
• Spreader will spread temporal, spatial, form and
  substitutional relationships.

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Types of spread

• Temporal relationships involve carrying charges
  such as storable commodities such as corn, wheat,
  soybean
• Spatial spread The price relationship between
  gold trading in New York Futures gold and Chicago
  Futures gold
• Form Spread The soybean complex offer form
  spread because both soybean and products have
  futures contract
• Substitutional spread

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Speculative Strategies

• There are no strategies that consistently produce
  profitable trades. However, there are some
  general accepted speculative behaviors
• The three major behavioral concepts are
• Fear and Greed
• Puking
• Discipline

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Speculating Behavior

• Fear and GreedAre said to major reasons why
  orders are placed and lifted.
• The hallmark of a successful speculators is that
  they understand the greed within themselves and
  others and use it to their advantage. They
  formulate trading strategies that limit their own
  greed and exploit other peoples greed.

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Speculating Behavior

• Puking Also know as ego. Puking is the ability
  to recognize that you have made a mistake,
  correct it and re-evaluate it, time after time.
• Discipline It helps speculators develop trading
  plans and follow the plans.
• Most speculators dont trade with a definite plan
  and most dont stick to their plan. But plan is
  necessary for long-term success.

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A simple trading plan

• Cut losses and let profits run